Understanding the Credit Card

In our new financial literacy column, Arian discusses that life-changing piece of plastic: the credit card.

Photo credit: www.ccPixs.com, creative commons Flickr

It’s Your Money, with Arian Bacaliu

There is a piece of plastic out there that not even the red Solo Cup can compare with when it comes to exciting college kids – the credit card. Yes, the credit card, the things that make you ask, how the hell did I spend so much on coffee last month?! Let’s take a technical look at what it is, how you should use it, and things you should be wary of as a college student.

A Revolving Line of Credit

Credit cards work on the banking principle of revolving credit. The card comes with a credit limit, and as you use the card the funds available to you close. As you make payments on the card, the funds once closed become open for use again. For example, you take a card with a $500 limit and buy a $400 TV. Now the card’s available balance is only $100; to get that back to $500, you will have to make a $400 payment when the bill comes. If, say, you only make a payment of $100, then the card would have an available balance of $200, with $300 still closed off and outstanding. As you pay back the money you spent, that money is open again for use, so if next month you make a payment for $300, then the original limit of $500 is free for use again. With a traditional, non-revolving line of credit (like a car loan), once you pay it off it is done – that money is not made available to you again. But with a credit card, that money will be made available for use over and over, just as long as you keep paying it back.

Understanding APR

APR, or Annual Percentage Rate, is the cost associated with borrowing money, as it determines how much you pay back in interest. With credit cards, this rate is charged on any outstanding balance after a billing period is closed and can range anywhere from zero to 24.99 percent (and sometimes even higher).

To get a better understanding of APR, let’s use the example above. If you were only planning on making the typical minimum monthly payment of $25 at an APR of 17 percent on your $400 credit card bill, it would take you 19 months to pay it off, and you would have paid back a total of $56.86 in interest alone. So, that $400 you spent 19 months ago wasn’t really $400, it was $456.86.

The amount paid in interest can vary vastly. To see this in action, let us lower the monthly minimum payment to $15 and raise our APR to 24.99%. With these adjustments, it will now take you 40 months to pay back the $400, and you will spend $189.78 on interest. In other words, that $400 TV just cost you $589.78. I hope you like your TV.

Understanding the Bill

When it comes time to actually pay the credit card at the end of the billing period you will have three choices:

1) pay only the minimum amount (which is what the bank hopes you do),

2) pay off the full amount (what you should do), and

3) don’t pay anything (what you should definitely not do).

The reason I recommend paying off the full statement balance is that by doing so you avoid paying interest. That means when you get your bill you look at the total outstanding balance and pay that entire amount, so the balance of your card at the beginning of the next billing period is $0.

You should not consider paying only the minimum, because if you don’t have the money to pay off the card in full, you shouldn’t have used it in the first place. The banks do not need any more interest income – just look at the skyline of any major city and that statement will become self-evident.

Utilization Ratio

Another important aspect of credit cards is the utilization ratio. The utilization ratio is the ratio of funds available to funds used, and it is a component of what makes up the infamous FICO credit score. The utilization ratio in our example is 80 percent ($400 used ÷ $500 available); this is very high and will have a negative impact on any FICO score.

Lenders want to see that you are a responsible borrower; that is the whole point of the FICO score. So, if you constantly run a high utilization ratio on all your cards you will be seen as a riskier borrower who uses almost all capital available to him/her – and this behavior will reflect poorly on your FICO score.

The optimal utilization rate is fiercely debated, but anywhere up to 20-25 percent is typically fine; any higher and you risk hurting your credit score as opposed to helping it.

Tips for the Student

The philosophy I hold when it comes to credit cards is that they are a tool to help with building and maintaining a decent credit score, nothing more. They should not be used to spend money we don’t already have.

When it comes to the card, the advice is simple: play it safe. Maintain a low utilization ratio, pay it off in full at the end of each billing period, and be very aware of the trouble you can get into with one in your wallet.

It’s Your Money is The New Worcester Spy’s new financial literary column by Worcester State Accounting Major Arian Bacaliu. Arian is a Worcester State University senior pursuing a B.S. in Business administration. 

If you have comments or questions about money/personal finance, please email Arian at abacaliu@worcester.edu. Your question may be addressed in a future piece!

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